No.
7 • April 10, 2006
The Path to Development:
When Does the Legal Environment Become Critical?
by James Gwartney and Robert Lawson
In many ways, a market economy is like a telephone or
Internet system. In the case of those network goods, the value
to the individual users increases as more people have tele-
phones or Internet hookups. Markets have this same charac-
teristic—the more people integrated into the system, the
greater the benefits to each participant. The market network
generates almost unbelievable benefits as the result of gains
from trade, specialization, expansion in the size of the market,
and the application of techniques of mass production.
Most of the consumer goods enjoyed by households in
North America, Western Europe, and other parts of the
developed world result from what Nobel laureate Douglass
C. North calls “depersonalized exchange,” that is, trade
between parties that do not know each other and will proba-
bly never meet. Those exchanges are coordinated by what
Nobel laureate Friedrich Hayek refers to as the “extension of
the market” from the local town or village to the region,
nation, and indeed the far corners of the world. Without the
market network, high levels of per capita income and mod-
ern living standards would be impossible.
However, the enormous benefits of the market network
cannot be achieved without a sound legal system. People
James Gwartney is an adjunct scholar at the Cato Institute and pro-
fessor of economics at Florida State University where he directs the
Gus A. Stavros Center for the Advancement of Free Enterprise and
Economic Education. Robert Lawson is professor of economics and
holds the George H. Moor Chair in the School of Management at
Capital University in Columbus, Ohio. Gwartney and Lawson are
the authors of Economic Freedom of the World: 2005 Annual
Report (Vancouver: Fraser Institute, 2005), which is copublished in
the United States by the Cato Institute.
Cato Institute • 1000 Massachusetts Ave., N.W., Washington, D.C. 20001 • (202) 842-0200
fax: (202) 842-3490 • www.cato.org
who live in countries where property rights are insecure,
contracts poorly enforced, and legal and regulatory verdicts
auctioned off to the highest bidder will not be integrated into
the worldwide market network. Without rule of law, the ben-
efits from trade will be limited to those derived from person-
alized exchange, trade among family members and persons
in the local neighborhood or village who know each other or
at least know about each other. Here, trade is based on per-
sonal knowledge, and contract enforcement is achieved
through family ties and social pressures. However, the bene-
fits derived from personalized exchange will be small com-
pared with those available through a depersonalized market
network based on enforceable contracts and rule of law.
The empirical evidence is consistent with this view. In
the Economic Freedom of the World report, published annu-
ally by the Fraser Institute, we measure the level of econom-
ic freedom in more than 120 countries by looking at 38 poli-
cy and institutional variables in five general areas: size of
government, access to sound money, international exchange,
regulation, and legal structure and protection of property
rights. Countries that are more economically free receive
higher scores on a scale of 1 to 10.1
The Legal Structure and Protection of Property Rights
area of the economic freedom index indicates the consisten-
cy of a nation’s legal structure with the protection of proper-
ty rights, unbiased enforcement of contracts, independence
of the judiciary, and rule of law principles. Among the
approximately 100 countries for which data were available
throughout the 1980–2000 period, 24 countries had an aver-
age legal system area rating of 7 or higher. Table 1 shows
that these 24 countries had an average per capita GDP in
2000 of $25,716 and an average annual real growth rate of
Table 1 Table 2
Sound Legal Systems, Income, and Growth Weak Legal Systems, Income, and Growth

Countries with Growth of per Countries with Growth of per

Average Legal Legal Capita GDP, Average Legal Legal Capita GDP,
Rating > 7.0 System Per Capita 1980–2000, Rating < 4.0 System Per Capita 1980–2000,
during 1980–2000 Rating GDP 2000 % during 1980–2000 Rating GDP 2000 %

Switzerland 8.65 $27,780 0.82 Indonesia 3.90 $2,970 3.69

United States 8.61 $33,960 2.12 Senegal 3.84 $1,450 0.57
Netherlands 8.58 $26,910 1.98 Sri Lanka 3.67 $3,400 3.49
New Zealand 8.51 $17,840 1.29 Pakistan 3.66 $1,870 2.46
Austria 8.49 $26,420 1.99 Honduras 3.62 $2,830 -0.13
Luxembourg 8.45 $53,410 4.26 Syria 3.56 $3,280 0.64
Denmark 8.41 $28,680 1.74 Iran 3.55 $5,720 1.09
Finland 8.36 $24,160 2.27 Nicaragua 3.54 $2,450 -2.26
Germany 8.36 $25,100 1.70 Peru 3.52 $4,630 -0.24
Canada 8.32 $26,840 1.69 Philippines 3.49 $3,790 -0.02
Norway 8.31 $29,200 2.42 Algeria 3.47 $6,150 -0.20
Australia 8.29 $24,550 1.96 Colombia 3.43 $7,010 1.04
Iceland 8.08 $28,910 1.67 Uganda 3.42 $1,450 2.23
Sweden 8.05 $23,650 1.66 Nigeria 3.34 $860 -0.93
Belgium 7.97 $25,220 1.91 El Salvador 3.27 $5,240 0.57
United Kingdom 7.91 $23,580 2.29 Congo, Rep. of 3.27 $950 0.37
Ireland 7.91 $30,380 4.91 Bolivia 3.20 $2,310 -0.28
Singapore 7.89 $23,700 4.92 Bangladesh 3.19 $1,540 2.57
Japan 7.84 $25,280 2.34 Guatemala 3.02 $4,430 -0.08
Portugal 7.50 $17,710 2.91 Haiti 2.98 $1,920 -2.39
France 7.48 $23,490 1.72 Congo, Dem. R. 2.38 $730 -5.31
Hungary 7.16 $11,960 1.31 Average 3.40 $3,094 0.33
Hong Kong 7.16 $25,180 4.07
Taiwan 7.03 $13,279 6.00
Average 8.05 $25,716 2.50 expansion of the market provide the underpinnings for our
modern living standards, and a sound legal system is essen-
tial for the realization of those gains. Without a legal system
2.5 percent over the two-decade period. The lowest per capi- capable of enforcing contracts and protecting property rights,
ta income among these 24 countries was approximately trade will occur mostly among parties who know each other,
$12,000. Perhaps even more important, all 24 of the coun- and it will cover only a relatively small geographic or market
tries with sound legal systems achieved positive real growth area. The gains from depersonalized trade and an expanded
of per capita GDP over the two decades. market will continue to go unrealized. Without the realiza-
At the other end of the spectrum, there were 21 countries tion of those potential gains, it will be virtually impossible
with an average rating of less than 4 in the legal system area for countries to move up to even lower-middle-income sta-
during the period from 1980 to 2000. Table 2 indicates the tus. Tragically, they will continue to stagnate at relatively
income levels and growth rates of these countries. Their low levels of income.
average 2000 per capita GDP was $3,094, and their growth
rates averaged 0.33 percent over the two decades. Both of Notes
these figures were approximately one-eighth of the compara- This text is based on James Gwartney and Robert Lawson,
ble figures for the countries with sound legal systems. The Economic Freedom of the World: 2004 Annual Report
highest per capita GDP in 2000 among the 21 countries with (Vancouver: Fraser Institute, 2004), pp. 35–37.
low-quality legal systems was Colombia’s $7,010. None of
the 21 countries with low-quality legal systems was able to 1. For country rankings and ratings and for a detailed description
achieve both a 2000 per capita income of more than $3,400 of the methodology and sources, see James Gwartney and Robert
and a growth rate during 1980–2000 of more than 1.1 per- Lawson, Economic Freedom of the World: 2005 Annual Report
cent. Thus, none of the countries with unsound legal systems (Vancouver: Fraser Institute, 2005). For more evidence that institu-
was able to sustain a solid rate of growth once income levels tions play a key role in development, see International Monetary
rose above $3,400. Fund, World Economic Outlook (Washington: IMF, September
The gains derived from depersonalized exchange and 2005), pp. 125–60.